The Gotcha Regulation

Rep Chris Collins, who also happens to be a director of Innate Immunotherapeutics, has been charged with insider trading by Federal prosecutors. From the description in the media and the process of connecting the dots from a call to his son who told others, the case that he breached his fiduciary duty appears to be strong.

However, the case against insider trading is not as clear cut as it is generally made out to be. The law as contained in the Insider Trading Act of 1988 defines penalties for insider trading for someone who is guilty of breaking SEC rules when using material, non-public information to trade securities, or when passing on information to another person who acts upon the information. But there is no is no statutory definition of insider trading and not all insider trading is illegal. As a result, the SEC can distort its definition any way it wants and there are numerous examples of it doing so in the past. Writers have documented many allegations of insider trading that were based on weak evidence.

There is a fine line between what is legitimate insider information and what isn’t. In today’s high-tech world professional traders exploit all relevant sources of information. In making judgments about whether information is legitimate or not, a major consideration is the source. Is it second or third hand, is it information that anyone can obtain by a little research and drawing inferences, or is it from a banker, lawyer, or corporate officer who has a fiduciary duty to protect certain information?

Trading is illegal when the SEC asserts that it concludes that information used in making a buy or sell decision was obtained from a breach of fiduciary duty, or a duty arising from a relationship of trust or confidence. The contention is that those possessing insider information that is not public should not be able to benefit or help others to benefit when other shareholders cannot similarly benefit. On the surface, that seems fair and reasonable but there is a school of thought that holds an opposing view, a view based on an understanding of how markets work and the value of knowledge. When an “insider” uses non-public information to buy or sell stocks, that act sends a signal to the market that can produce information that other share owners can use in making their buy and sell decision. The case for insider trading is based on improving market efficiency.

In the 1960s, Henry Manne, one of the founders of the school of law and economics and a former dean of the Scalia School of Law at George Mason, wrote a book challenging the assertion that insider trading imposed harm on shareowners and the market. His basic thesis was that more information makes the stock market more efficient and accurate no matter how that information is acquired. Manne’s points were that the practice of insider trading did no significant harm to long-term investors while it contributed to more efficient stock market pricing. Over the past 50 years, insider trading has been strongly defended in scholarly journals. Nobel Laureate Milton Friedman argued that insider trading is a good thing, allowing market prices to more quickly reflect important information.

Since insider trading as defined by the SEC includes both legal and illegal trading, many have made the argument that the present law simply cannot be effectively enforced because it impossible to define the activity in a way that would not also bar legitimate research and trading. Hence, the SEC has a blunt instrument that it can use to construct a case asserting violations on the basis of presumptions of knowledge because producing definitive and convincing evidence is not easy. Manne made the argument that insider trading is what bootlegging was to the probation era. Meaning that authorities can’t stop it: “The imagination of wealth seekers in using valuable information in the stock market will always outpace the ability of regulators to cope.”

It is doubtful that Congress will ever rein in the SEC or make insider trading legal because it is too easy to demagogue against doing so. But Congress can act to constrain regulatory abuse and raise the bar on what constitutes evidence. The need for a better and more objective standard was demonstrated in the insider trading case against Martha Stewart. In spite of her trying to back date records concerning her selling, there was no proof that she was aware that the advice she got from her broker was non-public or that she knew of a failed drug trial that caused the stock of ImClone to crash. More recently, the SEC accused professional golfer, Phil Michelson, of insider trading because he acted on a tip from a gambler to whom he owed money. There was no evidence that he knew that tip was insider information. Other cases of insider trading have also rested on assumed SEC prescience and connecting dots from a preconceived conclusion.

The system shouldn’t work that way. If Congress will not act for political reasons that leniency is selling out to the wealthy and Wall Street, at least it should set a clear standard that innocence should be assumed and guilt proven by a preponderance of factual evidence.